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Global Impact Of 2008 Financial Crisis
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Pdf] Global Financial Crisis, Its Impact On India And The Policy Response
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This essay is adapted from a series of blog posts covering the Asian Monetary Policy Forum held in Singapore on May 24. The forum was hosted by Chicago Booth, the University of Singapore Business School and the Monetary Authority of Singapore.
When the global financial crisis hit in 2008, risk premiums and borrowing costs around the world skyrocketed. Then, in May 2013, when Ben Bernanke, then the chairman of the Federal Reserve, suggested that the Fed might taper bond purchases sooner or later, emerging market bond yields rose sharply. Currency values in Brazil, India, Indonesia and Turkey, to name a few, were also under severe downward pressure. These incidents show the vulnerability of developing economies to financial shocks and uncontrolled risks. They pose difficult challenges for policy makers in developing countries.
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Maurice Obstfeld, professor of economics at the University of California, Berkeley, presented a thoughtful paper at the first Asian Monetary Policy Forum (AMPF), an event co-sponsored by Chicago Booth, held in Singapore in May. This paper describes this issue. Mr. Obstfeld’s paper assesses the ability of developing countries to use monetary and macroprudential policy tools to mitigate the domestic impact of global financial forces.
In considering this issue, the first thing to do is to recognize the power of global financial forces that create and increase stress in the financial systems of developing countries and their economies. Even with strong growth records, persistent current account surpluses, and relatively strong financial systems, developing economies are vulnerable to effects that could undermine these strengths. Global financial forces affect emerging markets in different ways.
First, let’s look at the relationship between interest rates. Mobile financial capital transmits financial conditions internationally through interest rate term premiums and risk premiums, which affect the value of assets and the cost of assets in domestic economies. We see the impact of the global financial crisis on the borrowing costs of Korean companies. As the crisis deepened after August 2008, borrowing costs rose sharply, more so for companies with lower credit ratings. This increase in borrowing costs has constrained the investment spending and hiring activities of Korean companies.
Recall the dramatic events of September 2008. Rising losses on mortgages and mortgage-related securities and guarantees forced the US government to put Fannie Mae and Freddie Mac into conservatism on September 7th. Lehman Brothers filed for bankruptcy on September 15, putting pressure on financial markets around the world. The next day, losses on Lehman Brothers bonds caused the Federal Reserve to “cash out,” triggering a widespread run on money market funds. The US Federal Reserve and Treasury responded quickly with unprecedented policy action to stem the panic and fund US money markets. On September 17, the US government took control of insurance giant AIG to avoid what policymakers saw as a potentially catastrophic failure. A week later, the Federal Deposit Insurance Corporation of Washington closed Mutual, making it the largest commercial bank failure in US history.
The Global Financial Crisis Of 2007 08
Although the initial epicenter of the crisis was the US financial system, global financial linkages meant that the shocks associated with these events to borrowing costs in South Korea and other countries quickly subsided. South Korean policymakers had limited ability to contain or offset these developments, and the South Korean economy suffered as a result.
Obstfeld provides evidence that monetary policy allows developing economies to buffer some of the impact of external shocks on domestic short-term interest rates. However, long-term interest rates are not very responsive to domestic monetary policy, and even developing countries with flexible exchange rate regimes are subject to global financial conditions. Shocks and developments elsewhere can sharply increase the cost of funds in the domestic economy and reduce asset valuations.
We often see interest rate linkages work in extreme situations, but they work just as well in more relaxed times.
To understand its impact, consider US monetary policy and its effects on other countries. Since the global financial crisis (and for some influential people even before that), the United States has engaged in extremely accommodative monetary policy. In an effort to support the economic recovery, the Fed has kept short-term Treasury yields close to zero and introduced tools to compress risk premiums, lower borrowing costs and lower bond yields. These measures, combined with slowing growth and the absence of strong inflationary pressures, have kept nominal US interest rates unusually low for several years.
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Countries that have adopted the US dollar as their primary currency, such as Ecuador, Panama, and East Timor, directly inherit these US monetary and financial positions. The same is true of jurisdictions such as Hong Kong, which operate with open capital markets and a fixed and reliable exchange rate to the US dollar. It is also important to recognize that a significant number of dollar-denominated credit transactions occur outside of US borders. Obstfeld notes that U.S. dollar bank loans to non-financial institutions outside the United States currently account for 35% of U.S. domestic bank loans. Similarly, US domestic bank lending to non-financial institutions is roughly the same as the country’s annual GDP. In other words, the Fed’s actions directly affect interest rates and credit conditions in many parts of the world.
The consequences of US monetary policy are more complex in countries that restrict international capital flows or fluctuate their exchange rates against the US dollar. In principle, countries with open capital markets can conduct independent monetary policies by allowing their currency to float freely in foreign exchange markets. In practice, most countries and currency areas operate on managed floats, resistant to large and rapid exchange rate corrections. One reason for this is that large fluctuations in exchange rates have an important impact on the cost of living of domestic consumers and the ability of domestic producers to export goods and services. Exchange rate issues are of particular importance in small and highly open economies.
As Obstfeld explains, there is little demand for a fully flexible exchange rate regime. For example, if we were to rely on current exchange rates to fully accommodate the moderate compression of risk premiums caused by United States monetary policy actions, the country would have to accept a relatively large appreciation of the currency. Whether for this or other reasons, very few countries allow their currency values to fluctuate freely. As a result, US monetary policy decisions affect interest rates and credit conditions around the world.
These international consequences are cause for concern for two primary reasons. First, mistakes in the conduct of US monetary policy have negative consequences around the world. Second, even if US monetary policy is optimally suited to US macroeconomic and financial conditions, other countries tend to have different, and sometimes very different, conditions. The second concern has been particularly relevant to policymakers in emerging economies in recent years. In many cases, they faced stronger inflationary pressures, more immediate concerns about threats to financial stability and stronger growth prospects than the US.
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International capital flows present other risks and potential distortions, creating additional challenges for policymakers in developing economies.
Capital inflows increase the elasticity of credit supply for the domestic economy. In a closed economy, the supply of domestic credit constrains excessive lending due to optimism about domestic economic prospects, whether justified or not. As borrowing increases and domestic supply limits are reached, higher interest rates affect the credit boom. In open economies, external credit can add additional sources of finance to developing economies, reduce constraints on domestic credit growth, and set the stage for subsequent major failures.
Changes in portfolio demand in rich countries are also a source of risk. For example, a shift in the portfolios of rich countries in favor of emerging market assets could lead to an increase in gross capital inflows, which would affect domestic financial conditions and asset prices. Obstfeld said:
If these portfolio changes are met through the intervention of the home country’s central bank, the inflows finance an increase in foreign reserves. Even if the central bank allowed the currency to appreciate instead, the net personal debt owed by foreigners would still rise, albeit gradually over time, due to shrinking current account balances. The Chinese case shows how both mechanisms can work simultaneously. Domestic financial situation with or without central bank intervention
Asian Financial Crisis
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